Remember credit default swaps? The derivatives that some hedge funds (and banks) used to make not-so-small fortunes betting against the housing market. The derivatives that, in the process, multiplied subprime losses, and made it impossible to know just where they'd turn up. The derivatives that sunk AIG.

Yeah, those derivatives.

These "financial weapons of mass destruction," as Warren Buffett called them, turn out to be pretty simple, in theory. Credit default swaps (CDS) are just insurance on a loan. So when you buy a CDS, you're betting against a loan. And it doesn't have to be a loan you made. You can bet against a loan someone else made too. It'd be as if you could take out car insurance on someone you think is a bad driver. So if the loan defaults, you stand to make money. And if there's no default, you just wind up coughing up premium after premium, paying for car insurance on your good driver who never gets in an accident.

What could go wrong here? Plenty. For one, CDS have been traded one-on-one, not over exchanges, so it's been hard to know just who owes what. This opacity was a big part why banks stopped lending to each other during the financial crisis — they didn't know who'd been stuck holding the subprime bag (or if it was them). For another, you could sell more CDS protection than you could ever afford to pay out if everything went bad. (This was AIG's $180 billion mistake). But there are some pretty simple fixes here, and the industry has adopted some of them. CDS trades are now publicly reported, and go through clearinghouses that require collateral. So CDS are more transparent, and it's harder to sell them if you can't afford to pay them.

But even with these financial shock absorbers, there are still lots of clever-and-probably-legal-but-ethically-dubious ways to game CDS. Here are the two most devious.

1. Buy CDS on a bond, and then bribe the borrower to temporarily default. This is like taking out insurance on your neighbor's car and bribing him to get in an accident. You get the insurance, and then you kick some money back to him to upgrade his car.

Sound far-fetched? It's not. It's essentially what a unit of the Blackstone Group did with the Spanish gaming operator, Codere SA. First, Blackstone bought insurance on Codere’s bonds, so it stood to make a nice bit of money if Codere missed an interest payment. But how do you make a company miss an interest payment? Well, Blackstone took over one of Codere's revolving loans, as a hostage, and told the gaming company: "We'll force you to pay back this entire revolving loan unless you kindly miss the next interest payment on your bonds." It was a clever ransom. And guess what? The clever ransom worked. The interest payment came late. Blackstone made $15.6 million from its CDS. And as for Codere, they turned out fine, too. Blackstone agreed to restructure its bonds, and reward the company for good behavior with another $48 million loan.

2. Sell so many CDS on a bond that you can pay to keep it from defaulting. This is like selling insurance to as many people as possible on a car that was obviously falling apart — and then paying to fix it before it could get in an accident.

Normally that would be the end of the story. Wall Street would look for a greater fool to insure this pile of toxic waste, but that great a fool doesn't exist. But what if it did? What if Wall Street could find someone crazy enough to insure all these bonds guaranteed to default? Well, that insurance would be expensive, and everybody would be happy to buy it. In fact, it'd be so expensive, and there'd be so many people happy to buy it that the fool who sold it all would have quite a bit of money upfront — enough to buy up all the bonds it had insured. And to buy them up at above-market prices, too!

See, there are certain types of bonds you can pay off before they come due if you pay an above-market price. Let's say our crappy bonds are these type of callable bonds. In that case, our fool who insured these crappy bonds has just made it so they will never default. Not so foolish after all.It's a risk-free profit, and it's what Texas-based Amherst Holdings did back in 2009. It sold about $130 million of insurance on $29 million of subprime bonds to banks like JP Morgan, Bank of America, and Royal Bank of Scotland. Then it paid above-market prices on those $29 million of bonds to prevent them from defaulting.

***

The problem with CDS is you can manipulate them to pay off, and you can manipulate them to not pay off.

The first is what economists call the "empty creditor" hypothesis. When a company gets in trouble, a creditor normally has every incentive to voluntarily restructure a bond rather than have it involuntarily restructured in bankruptcy. Better to make the deal yourself than a judge, who will rank your claim against everyone else's. But say a creditor has CDS on its bonds. Then that creditor might get more money by refusing to restructure, and forcing the company into bankruptcy. That's a less elegant version of what Blackstone did. It added in the wrinkle of bribing the company to only briefly default on the specific bonds it held, rather than going through bankruptcy. But Blackstone did put the threat of bankruptcy very much on the table by saying it would call in the company's revolving loan if the company paid its bond on time. The second is basically an empty contract. You sell insurance on something, and then act to make sure that insurance never pays out. It's harder to do, because there aren't many bonds you can pay off yourself that are also crappy enough to sell enough insurance on. In either case, it's money for nothing.

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